Protecting Clients Finances from Tax Law Changes

With the election out of the way and efforts taking shape in Washington to resolve the threat of automatic tax increases and the fiscal cliff, CPAs and certified financial planners are recommending ways to protect their clients no matter what Congress and the Obama administration ultimately decide to do about the tax laws for next year.

Rick Rodgers, CFP, president of Rodgers & Associates, “The Retirement Specialists,” in Lancaster, Pa., advocates that clients diversify their income by putting it in various types of retirement accounts and investments.

“Put some money into a Roth IRA because the withdrawals will be tax free, and into tax-deferred accounts like a 401(k) or a 403(b) because you get the immediate tax benefits this year,” he said in an interview Wednesday. “Then save some money after tax because currently the earnings on investments in after-tax accounts are preferential in terms of qualified dividends and long-term capital gains. That way, you have your money in three different places. Going forward, we don’t know what’s going to happen with the tax laws, but that way you’re somewhat covered as opposed to making a big bet one way or the other.”

Rodgers thinks it is likely that Congress and the Obama administration will decide during the lame duck session to extend the current tax rates as enshrined in the Tax Relief Act of 2010 for another year and try to tackle tax reform next year.

“I don’t think that anybody thinks this current system of patch and postpone is good for anybody,” he said. “Here we are again wondering what’s going to happen with the current tax laws. For tax preparers, CPAs and financial planners, how do we advise clients?”

Mark Fagan, CPA, managing partner of the Connecticut office of Citrin Cooperman, which is part of the Moore Stephens North America association, has several predictions about what he thinks the Obama administration will propose. “The top individual income tax rate of 35 percent will revert back to 39.6 for all earners above $250,000,” he said.

“The tax rate for dividend income will increase from 15 percent to 39.6 percent for earners above $250,000," he added. "Long-term capital gains rates are expected to increase from 15 percent to 20 percent for earners over $250,000. The alternative minimum tax will be extended. The corporate tax rate may actually decrease from 35 percent to 28 percent, but corporations will lose certain deductions. Renewable energy credits are expected to be extended under Obama."

But the question is whether such proposals from the administration will be able to make it through the House and Senate.

“With a Republican House and Democratic Senate, there will certainly be compromises to many of Obama’s tax initiatives,” said Fagan. “I believe the long-term capital gains tax will get through Congress, and there is a strong chance the individual rates will increase.”

One of the unresolved issues is the alternative minimum tax, which has not yet been patched to prevent it from applying to millions more taxpayers next year. “We could say we think the alternative minimum tax is going to be patched, but nobody really knows if that’s going to happen,” said Rodgers. “We’re going to be dealing with that forever unless we have tax reform. The President has said that he wants to get rid of the alternative minimum tax, but he hasn’t been specific on how he proposes doing it. The only way for that to happen is through some kind of tax reform and overhaul of the tax system.”

In the meantime, Rodgers is advising clients to do a Roth IRA conversion now before the end of 2012. “We still have about six weeks or so to do a Roth conversion,” he said. “The great thing about the Roth conversion is that we can decide up until Oct. 15, 2013 to undo it. So we can do a Roth conversion anticipating that rates will go up, or some kind of thing will happen with the Tax Code that is unfavorable. But if we find out that doesn’t happen, or if maybe tax reform goes through and we should not have done a Roth conversion, we can always undo it. So since we can undo it, why not do it? For most people, if you can afford to pay the tax on it and you end up keeping the Roth conversion, do a Roth conversion for more than you think you should because you can always undo part of it as well, so it’s not an all or nothing.”

Rodgers also advises taking capital gains this year rather than waiting until next year. “I think that applies to two sets of people,” he added. “The first one would be anybody who can take capital gains in the 15 percent bracket because currently, in that bracket, capital gains are taxed at zero. The only thing that you have to consider when taking capital gains is if you live in a state that has state income tax and that applies to capital gains. I think you seriously need to consider doing that this year. Even if you like the security, take the capital gain and then buy it back.”

Rodgers believes that taxpayers who will be subject to the additional 3.8 percent tax on investment income under the Affordable Care Act should consider taking capital gains to re-establish their cost basis. “If you know your income is going to be over $250,000 next year, accelerating capital gains into this year it’s going to be taxed at 15 percent,” he pointed out. “Next year, it’s going to be 18.8 percent. But if you’re between $70,000 in taxable income and $250,000 in adjusted gross, that’s really a unique situation that involves some serious planning. We certainly are talking to our clients about it, looking at their situation to see if it makes sense to do it or not. But it’s not as easy for me to paint this big brush and say that’s something you should definitely do.”

Another type of client who needs to do more planning is one who itemizes medical deductions. Total medical expenses in excess of 7.5 percent of a taxpayer’s adjusted gross income can be deducted this year, but next year the threshold will increase to 10 percent. “It means things like paying your premium ahead of time, having your checkups done in December rather than January,” said Rodgers. “If you normally itemize medical expenses, you want to take them this year rather than next year.”